When Are Legal Costs Nondeductible?

In a recent tax ruling, an appeals court contrasted an insurance company and a landlord.Robert Willens, CFO.com | USMay 31, 2011

In the 1990s, Anthem, the predecessor of WellPoint and a for-profit seller of health insurance policies, acquired three nonprofit Blue Cross Blue Shield units — one each in Connecticut, Kentucky, and Ohio. Since both Anthem and the acquired Blues were at the time mutual insurance companies, the mergers had no tax consequences: the policyholder-members of Anthem and of the three acquired companies voted to merge. And the mergers made them all members of Anthem, which is now WellPoint.

But sometime after the acquisitions, the attorneys general of the three states of the acquired companies each sued WellPoint, charging that it was using the acquired assets to make profits. That would violate the restrictions that the charitable status of the acquired companies had placed on the use of their assets, the AGs contended. Eventually, WellPoint agreed to a settlement in which it paid $113,837,500 to the states.

In a decision later upheld by the U.S. Tax Court, the Internal Revenue Service refused to allow Wellpoint to deduct that amount from its taxable income or the legal expenses it incurred in the litigation with the AGs. The Tax Court held that WellPoint's settlement payments were capital expenditures, not ordinary and necessary business expenses. In March 2010, the Court of Appeals for the Seventh Circuit upheld the Tax Court's decision.

In its analysis, the appeals court explained the difference between a capital expenditure and an ordinary and necessary business expense via examples. The cost of buying a building, for instance, is a capital expenditure because a building has "a useful life substantially beyond the taxable year," which is the legal definition of "capital expenditure."

A capital expenditure isn't deductible as a business expense in the year in which it's made. Instead it must be depreciated over its useful life, and the amount of depreciation each year is all that's deductible that year, according to the appeals court. Thus, as required by tax law, cost is matched temporally with revenue.

In contrast, the court reasoned, business expenses incurred in the course of day-to-day operations are ordinary business expenses. If they're also "necessary" (meaning "appropriate and helpful"), they're deductible from the business's taxable income in the year in which they're incurred.

Thus, in the court's example, repairs to a building that preserve but do not enhance the building's value can be expensed. On the other hand, improvements intended to boost the building's value must be capitalized.

Like repairs that prevent a building from collapsing, expenses paid out to defend title to the building are incurred to protect the building against what, from the owner's standpoint, might be a loss equivalent to its collapsing. "But such expenditures, because incurred to defend (or assert) the ownership of a capital asset, cannot be expensed," the court stated in its decision.

The particular expenses involved in the WellPoint case were incurred in defending a lawsuit, according to the decision. A business sued for unpaid taxes or unpaid rent, for instance, may deduct its expenses in defending the suit as ordinary business expenses.

Such costs are "incurred to preserve the operation and profitability of the business rather than to acquire or retain or improve a specific capital asset," the court reasoned. Thus, they're "ordinary and necessary" even though they aren't as regular and predictable as costs of labor and materials.

The court noted that such arguments over how to characterize expenditures are resolved by applying the "origin of the claim" doctrine. "Costs incurred in defending a lawsuit are classified as expenses or as capital expenditures depending on the nature of the claim that gave rise to the litigation," according to the decision.

In the court's building-code example, the landlord's litigation payments were made in lieu of proper maintenance. "So they are treated like the repair expenses for which they are a substitute, and thus can be expensed," it reasoned. "But if the landlord were defending against a suit for specific performance of a contract to sell the building, he would be defending the ownership of his capital asset and so the origin of the claim would be a dispute over title."

Wellpoint always claimed to have equitable title to the acquired assets. But the expenses that it reasonably incurred to defend that claim — the claim to own the assets free and clear — constitute nondeductible capital expenditures, the appeals court ruled.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.